Dummies_Swing Trading

37Chapter 2: Understanding the Swing Trader’s Two Main Strategies

The role of psychology in fundamental analysis

You can see how psychology comes into play any bearing on those future events. Called
with fundamental analysis when analysts anchoring, it’s a trait we all suffer from. If you
under- or overestimate a firm’s potential through bought shares of a security at $15, for example,
earnings surprise data. Earnings surprise fig- and watched them fall to $10, you may decide
ures show how positively or negatively a com- to sell when your shares trade at $15 again.
pany’s earnings come in versus Wall Street’s But this may not be the right course of action.
consensus expectations. Wall Street analysts You’ve anchored your expectations of exiting to
consistently underestimate great growth firms’ a past price ($15) that may no longer represent
potential, and that underestimation is revealed the security’s true value. In other words, you
when those firms post positive earnings sur- may be waiting a long time to break even —
prises. Similarly, Wall Street analysts often just ask shareholders in Nortel Networks, who
overestimate the difficulties at troubled firms, saw prices fall from more than $800 to $11 in a
and that overestimation is revealed when those few years.
firms post negative earnings surprises.
I often talk about Wall Street’s biases. Just
So how does psychology play a role in these remember that those biases are inherent in you
surprises? It turns out that many Wall Street and me, too. So try to guard against falling in
analysts project future events based on infor- love with positions or waiting to break even.
mation known today that may or may not have

The advantages of fundamentals are centered on the focus on value — what a
firm is actually worth. Fundamental analysis

ߜ Estimates a firm’s intrinsic value regardless of where the market trades
ߜ Incorporates industry and market effects, which can drive security

prices in tandem
ߜ Wins out over the long term — fundamentals drive the prices of securities
ߜ Assumes the market is wrong at times

Of course, fundamental analysis also has its shortcomings because it

ߜ Can be incorrect in the short term when you most need it
ߜ Is more subjective than technical analysis
ߜ Relies heavily on your skill to interpret relevant market information
ߜ Doesn’t provide reference points on exits should your assumptions be

incorrect

38 Part I: Getting into the Swing of Things

A fundamentals-based swing trading success story

If you frequently get your business and financial Cramer was a contrarian who took long positions
news from the television station CNBC, you’ve (bought) in stocks that had fallen a significant
no doubt seen the colorful character known amount, or took short positions in stocks that had
as Jim Cramer, host of the show Mad Money. risen a significant amount. He traded securities
He greets callers on his show with a big “Boo- whose price was affected by corporate news,
Yah!” and takes questions on most any com- such as an upgrade or downgrade by a Wall
pany in the market. Street firm. Sometimes he traded securities
before they reported earnings if he felt he knew
Cramer’s rise to stardom was predicated on which way the reports would go. His trading was
his success at a hedge fund he founded in fundamentals-based — if Home Depot announced
1987. Cramer reportedly generated returns poor earnings, it may signal that Lowes’s earn-
of 24 percent per year for a decade after the ings would also disappoint. However, he diverged
launch of his firm (he was holding cash during from the traditional day or swing trader in his use
the October crash in 1987) before cashing in of the media to get his opinions out on securities
during 2001. Though Cramer extols the virtues of he owned or was short.
buy-and-hold investing on his show, he traded
so frequently during his hedge fund years that I highlight Cramer as an example of a
he likely would’ve been classified as a swing fundamentals-based short-term trader. He
trader or day trader (his firm often generated didn’t rely on charts or technical indicators. He
the most in commissions among major Wall has even disparaged technical analysis on his
Street hedge funds). Cramer’s books aren’t filled TV broadcasts. But his style is instructive in the
with charts and technical indicators. Rather, he ways a trader can swing trade on news events
talks fundamentals. He was a short-term trader that the market gets wrong or that the market
— very short term. reacts too strongly to.

I don’t recommend exiting based on a company’s fundamentals. All too often,
a security’s shares make their move before the reasons for that move are fully
known. As a swing trader, you’re better off basing exits on the strength or
weakness in the price chart (depending on whether you’re short or long the
security). Stock prices fall faster than they rise, and commodities tend to rise
faster than they fall. If you’re long stocks, you want to exit quickly because
of this characteristic. Fundamentals change too slowly to react in a timely
manner on an exit. Use stop loss orders in any case to protect your downside.

Looking at catalysts and the
great growth/value divide

Fundamental analysis is principally concerned with a company’s value (or
perhaps more accurately, what a company’s value appears to be). But even
a company that is undervalued may stay undervalued unless some catalyst
occurs to cause other investors to revalue shares higher.

39Chapter 2: Understanding the Swing Trader’s Two Main Strategies

Watching for catalysts

To help make up for the main weakness of fundamental analysis — the issue
of timing — swing traders rely on catalysts. Catalysts are fundamental events
like mergers, acquisitions, new products, and earnings release dates that
affect short-term price movement and spur the market to correctly value
a company’s shares. They can be internal or external, and you should pay
attention to both.

ߜ Internal catalysts: Events that a company has direct control over are
internal catalysts. They come in the form of new services or products
(consider the splash that Apple’s iPhone made when it debuted) or new
management (a change in the CEO position at Hewlett-Packard helped
propel shares higher).

ߜ External catalysts: External catalysts include such events as consolidation
in an industry (when a company is bought out, its competitors are often
assigned higher valuations because they’re seen as potential targets) or
changes in commodity prices (for example, oil or natural gas prices).

As a swing trader, you should look for opportunities to trade when a firm’s
fundamentals change because of one of these events — or when the percep-
tion of a firm’s fundamentals changes (such as when a company surprises Wall
Street with its earnings report). Consider a real-life example: Homebuilders’
shares were overvalued for much of 2005. If you shorted shares of some of the
top homebuilders then, you would’ve had your head handed to you. But if you
used fundamental analysis, you may’ve waited for a catalyst — an event that
would cause repricing of homebuilder shares. That event came in August 2005
when, for the first time in many months, the growth rate of contracts for new
homes slowed. (Security prices of fast-growing firms often peak when growth
rates begin to decline, not when growth turns negative.)

Classifying a company according to growth or value

Fundamental analysts usually classify companies as either growth firms
or value firms (though many ardent investors argue that growth and value
investing are two sides of the same coin). Even though growth investing and
value investing are associated with long-term investing, swing traders need to
be aware of the differences, because growth stocks and value stocks outper-
form each other at different times.

ߜ Growth stocks: Companies that typically trade at premiums to the over-
all market (as defined by price to book ratios or price to earnings ratios)
are growth stocks. They tend to be in industries that experience high
growth rates, like technology and healthcare.

ߜ Value stocks: Companies that typically trade at discounts to the overall
market (as defined by price to book ratios or price to earnings ratios)
are value stocks. They tend to be in the financial sector and the con-
sumer staples sector (for example, companies in the beverage or food
industries are considered to be part of the consumer staples industry).

40 Part I: Getting into the Swing of Things

During some years, value is in the lead; during other years, growth is out
front. Trading growth stocks when value is in favor, or vice versa, can be like
fighting a schoolyard bully with one hand tied behind your back. If you’re a
great fighter, you can pull it off. But it’s not easy.

The reason that value and growth stocks exchange leadership roles lies in
investor perception. At times, investors favor companies that pay dividends
(such as when the Bush administration cut taxes on dividend payments) or
companies that have steady cash flow streams. Value stocks shine during
these periods. Other times, investors favor strong earnings growth without as
much regard to price. Growth stocks shine at these times.

Is it enough to simply know which horse is in the lead? After all, if you could pre-
dict with reasonable accuracy whether growth or value would lead, you could
rely on your forecasting abilities rather than historical performance — which, as
I’m sure you’re well aware, isn’t a guarantee of future returns. Forecasting, how-
ever, has a problem.

Even if you’re right about which style of investing should be in the lead based
on all known evidence, that doesn’t mean that style will actually lead. In other
words, the market isn’t rational.

I remember meeting with investment consultants in 2005 who quizzed me on
whether value stocks would outperform growth stocks in the coming year.
In truth, I had no idea. I knew that it was growth’s turn to lead because value
had been in the driver’s seat for several years, and the valuations were com-
pelling on the growth side of the divide. But the market doesn’t always agree
with my analysis. The only reliable way I know to trade the growth/value
divide is by using technical analysis.

Long-term investors care little about who’s in the lead because they can afford
to wait for the time when their style is in favor and their stocks reflect that
value. Fortunately, as a swing trader, you don’t have to analyze the economic
situation and determine what lies ahead for growth and value stocks. Rather,
you can simply analyze recent history and bet with the trend. If matters
change, move your chips to the other side of the table.

Chapter 3

Getting Started with
Administrative Tasks

In This Chapter

ᮣ Finding a broker and opening an account
ᮣ Getting the scoop on those with the scoop — service providers
ᮣ Tracking your trades with a trading journal
ᮣ Staying positive to achieve positive results

Swing traders use brokers like any other market participant. But a swing
trader needs a different kind of broker than an investor or day trader.
What type of broker you choose depends on a number of factors. I break
down those factors in this chapter, and I also give you details on how to open
a brokerage account.

After you have your account up and running, you need to think about subscrib-
ing to certain services to help carry out your analysis. Some services are help-
ful for conducting screens of the market. Other services chart securities. Still
other services help you locate the cream of the crop by focusing on industry
group rotation. I recommend some key services in the pages that follow.

I also cover trading journals in this chapter. To be a keen swing trader, I
recommend that you keep a journal (not to be confused with a personal
diary) of your trades because a journal helps you refine your tactics and
improve your trading by allowing you to review what works and what
doesn’t.

This chapter assumes you have a working knowledge of the financial markets.
You should also know how to use the Internet so you can try out some of the
brokerage options and service providers that I mention.

42 Part I: Getting into the Swing of Things

Hooking Up with a Broker

Why is the firm that executes all your trades called a broker? Not exactly an
enticing name, is it?

Despite the name, brokers are necessary for swing trading — or any kind of
trading, for that matter. But not all brokers are created equal. Some specialize
in offering custom advice and wealth-management services for the high net
worth individuals out there. They charge outrageous fees to execute trades
because, well, they can. Of course, they’d argue that those outrageous fees
simply reflect the cost of their advice.

Swing traders don’t use such plush services. Their brokers have more of a
no-frills approach. But the nice thing about competition is that even the no-
frills brokers are increasingly offering premium services like check-writing
privileges and ATM card access to brokerage accounts.

So how do you pick a broker who suits your needs? Read on.

Choosing a broker

When choosing a broker, traders all too often focus on a single factor —
commissions — to the exclusion of everything else. Commissions get the
limelight because they used to be the main impediment to frequent trading.

Not too long ago, swing trading wasn’t possible for the masses due to high
commissions. By law, brokers charged fixed trade commissions. But on May
1, 1975 (it’s okay if you forget this date after three seconds), securities laws in
the United States changed, allowing brokers to charge negotiated trade com-
missions. Commissions didn’t immediately fall to the levels they’re at today,
but they did fall over time. Today, you may pay a flat $5 to $12 per trade,
which may be equal to about a penny or less per share, depending on how
many shares you trade.

But not all brokers offer such competitive rates, nor do they all provide
the same services, so you must carefully consider the factors that are most
important to you when settling on a broker. Some of those factors include the
broker’s charting system, customer service, the ease of placing orders, and
the ease of depositing and withdrawing money.

Understanding the different types of brokers

What broker you choose depends on which services you want and how much
you’re willing to spend on commissions. Here are two classes of brokers to
consider:

43Chapter 3: Getting Started with Administrative Tasks

ߜ Discount brokers: Discount brokers offer fewer services to their clients
than full service brokers do. Instead, they focus on trade execution. You
tell them what to buy and sell, and they do it. Of course, trades are usu-
ally made electronically today instead of over the phone. You can always
speak to a living human being on the phone, but that will cost you more
for your trade. Discount brokers may provide some services for free, such
as research services or banking services.

ߜ Direct access firms: Direct access firms allow you to bypass a broker
and trade with an exchange or market maker directly. The advantage to
this approach is that you have more control because you can see who’s
offering or bidding for shares of a security and choose with whom you
want to trade. Direct access brokers often require you to download soft-
ware to your computer that provides faster streaming data than you’d
receive through a Web site. Some discount brokers are beginning to
offer direct access trading.

You may also encounter full service brokers, such as Merrill Lynch, who hold
their clients’ hands, offer a suite of services, and charge enormous commis-
sions. Obviously, full service brokers aren’t the choice of swing traders. A
swing trader who needs someone else’s advice on what to trade shouldn’t be
in the business of swing trading. Swing trading is about independence, not
dependence.

Searching for broker prospects

As a swing trader, you must use either a discount broker or a direct access
firm (see the preceding section for details on both). I’m not going to recommend
a particular broker for the simple reason that broker rankings change over time,
and a broker that provides great service today may not necessarily provide such
service in the future.

The major discount brokers you may want to consider include:

ߜ TD Ameritrade (www.tdameritrade.com)

ߜ E*Trade Financial (www.etrade.com)

ߜ Scottrade (www.scottrade.com)

ߜ Fidelity Active Trader (www.fidelity.com)

The major direct access trading firms you may want to consider include:

ߜ TradeStation (www.tradestation.com)

ߜ Interactive Brokers (www.interactivebrokers.com)

ߜ thinkorswim (www.thinkorswim.com)

ߜ Open E Cry (www.openecry.com)

44 Part I: Getting into the Swing of Things

Evaluating a potential broker

You need to consider a number of factors before choosing a broker:

ߜ Commission rate: Don’t pay more than a $10 flat fee, or more than one
to two cents per share for your trades. Trading with commission rates
higher than this amount isn’t necessary given what you can get from exist-
ing brokers. And, more important, the higher the commission rate, the
higher your returns have to be to cover the cost of those commissions.

Although I recommend specific rates in the preceding paragraph, trad-
ers tend to put too much emphasis on the commission rate and some-
times neglect other details when choosing a broker. Don’t fall into that
trap. The commission rate is important, but it’s not the sole factor you
should consider.

ߜ Trading other asset classes: A broker’s ability to offer you other markets
is becoming increasingly important. Ask your broker whether he or she
can arrange for you to trade international securities, futures contracts,
currencies, and so on. Expect to pay a premium for these additional
trading options.

ߜ Banking services: Some discount brokers offer banking services
like check-writing from your brokerage account or an ATM card that
accesses your portfolio. Most brokers allow electronic transfer of assets
so you can send and receive money from another bank account. These
types of services may or may not be important to you.

ߜ Usability: Usability refers to how user-friendly a broker’s trading inter-
face is. Some brokers allow swing traders to execute orders through
their Web sites; others require traders to download software onto their
computers. This factor can really only be addressed by taking a test
drive of a broker’s trading platform (be it a Web site or trading soft-
ware). Is it easy to enter orders? Is it easy to watch the market (if you
rely on your broker for market data)? I can tell you from experience that
TradeStation and TD Ameritrade have easy-to-use interfaces, but I recom-
mend you try out the brokerage options as you’re weighing this point
(some brokers allow you to use demo versions of their trading software
before opening an account).

ߜ Amenities: Amenities include research services and charting programs.
For example, a discount broker may offer you Level II quotes — which
enable you to see the order book for Nasdaq stocks; see Chapter 11 for
the scoop on using Level II quotes — or stock reports from Wall Street
firms for free or for a discounted fee. But I strongly discourage you from
relying on research reports. Besides the fact that almost everyone on
Wall Street sees them before you do, research reports aren’t very useful
because they’re rarely focused on short-term trading opportunities.

ߜ Customer service: You want to know that you can get someone on the
phone — and fast — when you have a trade or problem. How responsive
a company is to your complaints is next to impossible to determine

45Chapter 3: Getting Started with Administrative Tasks

without opening an account — unless you use media rankings. I recom-
mend relying in part on such rankings because they can be instruc-
tive — the writers share their experiences with a broker’s customer
service and other issues. Barron’s and Technical Analysis of Stocks &
Commodities are two publications that print broker rankings.

ߜ Portfolio analysis and reports: How much has your portfolio returned
year-to-date versus some major index? You can calculate this total on
your own (see Chapter 13), but it’s nice to have a broker who can run
the report for you. And when tax time comes, a broker with extensive
tax services can be a lifesaver.

Opening an account

After you’ve settled on a broker, you need to decide what kind of account you
want to open. You have several options, depending on whether you plan to

ߜ Borrow money to trade from your broker

ߜ Trade futures or options

ߜ Place the account in your name alone or in the name of your spouse as well

ߜ Designate the account as a retirement account or traditional brokerage
account

The next two sections help you answer these questions (save the spouse
question . . . that’s a discussion you need to have with your significant other —
sorry, I’m not that great at relationship advice).

Cash account versus margin account

After selecting your broker, you need to choose between opening a cash account
and opening a margin account. Cash accounts restrict your investable assets to
the cash available in your account. Margin accounts allow you to borrow money
from your broker to execute trades; they’re also necessary if you want to trade
options. A swing trader with $50,000 in cash sitting in a margin account can
usually borrow $50,000 to trade.

Borrowing is a double-edged sword: It magnifies potential returns but also
magnifies potential losses. If you borrow 100 percent of your assets and
invest the entire amount (for example, you deposit $50,000 into your broker-
age account and trade $100,000 in securities), a 10 percent loss is magnified
to a 20 percent loss. Not pretty.

Margin accounts can cause you to be more reckless in your trades. Money that’s
not yours (but that you have trading discretion over) is easier to gamble with
than money that is yours. Margin accounts may lead you to get in over your
head. If you’re new to swing trading, stick to a cash account — trading only with
your own assets is less potentially damaging to your overall portfolio.

46 Part I: Getting into the Swing of Things

Traditional brokerage accounts versus retirement accounts

Another question to ask yourself is whether you want to open a traditional
brokerage account or a retirement account. Traditional brokerage accounts
offer you easy access to your money. However, you must report your profits
on these accounts to the IRS as taxable income, unless the IRS classifies you
as a full-time trader, in which case you can convert capital gains and losses
into ordinary gains and losses. Why is that important? Because you can
deduct ordinary gains and losses against other income. If you’re not classi-
fied as a full-time trader, the maximum amount of losses that you can deduct
annually from pre-tax income is $3,000 (as of the date of this writing).

A retirement account, of course, solves the problem of taxes because it’s a
tax-deferred account. Unfortunately, the government limits how much you
can contribute to an Individual Retirement Account (IRA) in a single year
($5,000 in 2008 if you’re age 49 or younger). The government also limits when
you can withdraw the money without penalties (usually in the year you turn
59 1⁄2 ). So swing trading in a tax-deferred account is preferable if you want to
avoid the taxes that result from high turnover, but it isn’t preferable if you
plan to live off your profits.

Selecting Service Providers

No man (or woman) is an island, and no swing trader can trade without service
providers. But not all service providers are created equal. (Okay, okay . . . enough
with the clichés!)

Service providers differ in terms of the quality, timeliness, and breadth of the
data they supply, among other items. What you want in a provider is some
type of service — charting or access to a database of fundamental data, for
instance — that you can use for your benefit. In the following pages, I tell you
what to look for and what to avoid.

Providers to do business with

Data providers simply provide you with the tools for finding and charting secu-
rities and increasing your market intelligence. These tools should be flexible
enough to allow you to change inputs, such as what indicators to use for a chart
or what criteria to screen for in a database. I classify service providers broadly
into those that supply technical data and those that supply fundamental data.

47Chapter 3: Getting Started with Administrative Tasks

Technical software providers

Every swing trader must have a strong charting system. That charting system
must incorporate real-time charting and quotes (charts and quotes that reflect
live market data and aren’t delayed) if you plan on trading intraday. If you enter
orders after the markets close, you don’t need a real-time charting service.

The marketplace has many charting providers. Most discount brokers cater-
ing to the active trader club offer charting systems, and order entry is often
integrated with the charting functions (that is, you can program automatic
buys or sells when a certain action occurs in the chart).

Some of the popular charting programs in the marketplace include:

ߜ TradeStation (www.tradestation.com; the charts used in this book
are primarily taken from TradeStation)

ߜ MetaStock (www.equis.com)

ߜ Active Trader Pro (www.fidelity.com)

ߜ eSignal (www.esignal.com)

ߜ E*Trade Pro (www.etrade.com)

ߜ High Growth Stock Investor (www.highgrowthstock.com)

Several of these charting systems are integrated with brokers to allow for
easy order entry.

Which charting system is right for you depends on your needs. For example,
if you like to develop new indicators, you need a charting system with that
option. You must also consider the system’s ease of use and whether the
charts are appealing. A charting system should also have a wide array of indica-
tors that you can plot (the most popular indicators are covered in Chapter 5).
You should read independent reviews of charting systems to assist you in
your selection if you don’t already use a charting program regularly. I rec-
ommend reviewing the rankings published by Technical Analysis of Stocks &
Commodities in its annual Reader’s Choice Awards.

I use two charting systems: the one provided by my broker and another one
in which I conduct much of my own research.

Fundamental analysis software providers

Swing traders who opt to use fundamental analysis in their investment process
need to subscribe to data providers that can assist them in their research.
Fortunately, much of the fundamental data on a company —historical earnings,
returns on capital, expected growth, and the like — is available for free on
the Internet. I’m amazed at how much data is free for the taking online (am I
dating myself?).

48 Part I: Getting into the Swing of Things

Yahoo! Finance, Google Finance, and Reuters can address many of your fun-
damental data needs. And all three services provide fundamental data for
free. Following are a few more details on all three services:

ߜ Yahoo! Finance (finance.yahoo.com): I often begin my fundamental
data search at Yahoo! Finance. The Web site offers basic charting; head-
lines on a selected security; a company profile; competitor information;
analysts’ estimates (and historical earnings surprises); and financial
data from a company’s balance sheet, income statement, and cash flow
statement. But beware: Yahoo! Finance also has message boards that
you should avoid.

ߜ Google Finance (finance.google.com): Google is a newcomer to
the financial data distribution business. Google doesn’t provide as many
financial data fields as Yahoo! Finance, but it offers more data on inter-
national firms. I visit Google often when Yahoo! Finance doesn’t have
the data I’m looking for. Google calls its message boards “Discussions,”
which sounds harmless enough — but not everything is what it seems.

ߜ Reuters (www.reuters.com/finance/stocks): Yahoo! Finance and
Google simply present data taken from other providers, but Reuters
supplies its own data. The main data categories are Stock Overview,
Financial Highlights, Ratios, Estimates, Officers & Directors, Financial
Statements, Recommendations, and Analyst Research. My favorite
category is Ratios, shown in Figure 3-1. At a glance, Reuters provides
data on a company versus its peers and the overall market, so you can
quickly discern whether a company is priced at a premium or discount,
and whether that price is justified based on other ratios, like return on
equity or expected earnings growth rates.

In addition to these free research services, a few paid subscriptions are
worth your money:

ߜ Investor’s Business Daily: This daily newspaper provides fundamental
data on thousands of stocks. Each security is assigned an earnings rank
number and other fundamental data rankings.

ߜ High Growth Stock Investor: This software program, also known
as HGS Investor, provides top-down and bottom-up data services,
combining fundamental and technical data. The software is ideal for
fundamentals-based traders who screen sectors or the overall market
for trading candidates.

ߜ Zacks Investor Software: Yahoo! Finance, MSN, and Morningstar —
among others — offer stock screening services, but I consider Zacks
the leader in the business. Many of Zacks’s screening tools are available
online for free at www.zacks.com/screening/custom. Certain data
fields are available only to subscribers, but you can build effective
screens without a subscription. However, if you want to backtest a screen
to see how it would’ve performed historically, you must subscribe to
Zacks Research Wizard service.

49Chapter 3: Getting Started with Administrative Tasks

Figure 3-1:
The Ratios

page on
the Reuters

Web site
provides a
wealth of

data.

Source: Reuters Finance

50 Part I: Getting into the Swing of Things

Providers to avoid

If a service provider is charging exorbitant fees for its services, beware. You
can usually purchase top-quality charting programs for a small monthly fee,
and sometimes you can get them for free from your broker (assuming you
trade often enough with that broker). You can select stocks with software that
costs $600 per month, so be wary of high-priced services.

In general, avoid any type of service that tries to do the work for you. For
example, a service provider may tell you that ABC is overvalued or XYZ is
undervalued. Or it may tell you when to buy and when to sell. But think about
it: If that service really was exceptional at predicting when to buy and sell,
wouldn’t the providers of that service use it for their own profit? Why sell the
service? If I developed some model that accurately forecasted when to buy
and sell securities, I sure wouldn’t sell it to others!

Two types of specific services you should never consult are message boards
and newsletters or software programs that issue specific buy or sell recom-
mendations. Both of these services effectively delegate some thinking on
the part of the swing trader to someone else. But these services are popular
enough that I spend the rest of this section going into more detail.

Message boards: The kiss of death

If you find yourself browsing a message board, you may as well wear a
sign on your back that reads, “I’m lost.” My advice: Avoid message boards
because they won’t give you good intelligence and are likely to mislead you.
Here’s why:

ߜ The information on message boards isn’t objective. Generally, the sen-
timent on message boards is bullish. The majority of people posting are
excited about a company’s prospects and rave about how the widget
the company makes will revolutionize the world. Some people list their
target prices and how they recently picked up “another” $10,000 worth
of said stock. I’m sure they wouldn’t deceive us. (For an example of this
sometimes irrationally bullish outlook, see Figure 3-2.)

ߜ You can’t distinguish between competent and incompetent participants.
No credentials are required to post on the board except a pulse.
Although message boards do have intelligent posters mixed in with
masses of people who have too much time on their hands, you simply
can’t read them in the hopes of getting the opinions of the one or two
people who actually know what they’re talking about.

ߜ They’re annoying. You’ll get profanity (dressed up in numbers, of
course, to get by the Web site’s technical censors) and messages that
show that some posters are apparently unaware that a keyboard’s caps
lock can be turned OFF.

51Chapter 3: Getting Started with Administrative Tasks

Message boards are flooded with rumors and inaccuracies. Don’t waste your
time (or money) on them.

Figure 3-2:
Sigma

Designs
shares
declined
60 percent
over a
few weeks
in early
2008, yet
message
board
posters
remained
bullish as

ever.

52 Part I: Getting into the Swing of Things

Newsletters and software programs that issue buy/sell
recommendations: The not-so-harmless pack leaders

Many intelligent market experts out there write financial newsletters.
Newsletters tend to be of a higher caliber than message boards. Whereas
message boards are free to post to, newsletter writers depend on subscrib-
ers to continue their service. Hence, it’s tougher to make up things when you
may lose business as a result.

What I have a problem with are newsletters that recommend you buy or sell
this or that stock. As a swing trader, you must be independent. You aren’t
supposed to rely on anyone else’s expertise. Newsletters that stick to the
macro picture or industry group analysis are fine. You learn by reading those
newsletters.

But don’t think for a second that you have an edge in the market if you’re simply
replicating the buys and sells that a newsletter recommends. Even when the
newsletter has a good track record, you shouldn’t follow the recommendations
blindly. You’d be better off giving your money to a professional manager.

One software tool I suggest you shy away from is VectorVest. The service allows
you to type in most any publicly traded company and be told what the fun-
damental and technical picture looks like. It even tells you whether to buy or
sell that security. How wonderful. You don’t even need to think. VectorVest is
a quantitative model. It combines quantitative and qualitative factors to deter-
mine whether a security is a buy or sell. But what’s important is that it’s not
your model — it’s someone else’s. And anyone who subscribes to that service
is going to get the same recommendations as you would if you were to sub-
scribe. So how can you stay ahead of the pack when you’re running with it?

Starting a Trading Journal

Any system needs some type of feedback loop to improve itself. For example,
employees of most companies must complete annual performance reviews,
when their boss sits them down and tells them what they’ve done well (some-
thing? anything?) and what they can improve on.

Your progress as a swing trader is no different. A feedback loop is crucial so
you can make adjustments and improvements. Insanity was once defined as
doing the same thing over and over and expecting a different outcome each
time. If you trade securities without a feedback loop, I view that as a type of
insanity.

Your feedback loop should take the form of a trading journal in which you
record all your trades. The journal entries should be short and combine text

53Chapter 3: Getting Started with Administrative Tasks

that outlines the basics of the trade (like how you found it and what triggered
the entry) and charts that show what you saw before entering the trade
(which help you spot the readings of technical indicators, where resistance
and support levels were, and so on).

After a position closes (meaning you exit for a profit or loss), you can return
to the journal entry to discover what you did right or wrong. You may be
surprised at what you uncover. You may find that you should let profits ride
longer, for example, or take losses faster. Or you may realize that the nine-
day moving average isn’t such a great tool for signaling the beginning of an
uptrend.

Look for commonalities between your winners and losers after you’ve kept
your journal for a few months. If you’re like me, you may learn more from
your losses than you do from your gains. When you suffer a large loss, it can
be helpful to know whether the problem was due to the system itself or your
failure to follow the system. Then, if warranted, you can alter your trading
plan to improve the odds of success.

Your trading journal should include the following elements:

ߜ An explanation of how you found each trading opportunity

ߜ The positions you trade and whether they’re long or short

ߜ A chart of each security with any relevant indicators to assist in analyzing
the conditions of the market at the time you executed the trade

ߜ A miscellaneous section to record any additional information that may
be relevant at time of entry, such as concerns you had about executing
the position

ߜ A description of what triggered the entry

ߜ A post-mortem chart of the security with an explanation of what trig-
gered the exit

ߜ A rate of return after your exit

A trading journal can, of course, include a lot more information than what I’ve
presented here. For example, I don’t include certain items in a journal entry,
such as position size, that you can easily obtain from your broker. You can also
plot the industry group of the security, if applicable, or a chart of the overall
market. But the problem I’ve found with including too much information is that
you may fail to update the journal in a timely manner.

You must strike a balance between including too little information — to the
point where the journal isn’t useful — and including too much information —
to the point where the journal becomes a daunting task you fail to maintain. I
believe that if you use the criteria I list, you can achieve that balance. I provide
examples of trading journal entries in Figures 3-3 and 3-4.

54 Part I: Getting into the Swing of Things

Figure 3-3:
A sample

excerpt
from a
trading
journal.

55Chapter 3: Getting Started with Administrative Tasks

Figure 3-4:
A sample

excerpt
from a
trading
journal.

56 Part I: Getting into the Swing of Things

Creating a Winning Mindset

The final element you need to get started is a winning mindset. When I first
heard this rule of thumb, I thought it was too touchy-feely. But experience
and research studies have shown that there’s something to it. Fitness experts
often focus on a person’s mindset because they know that beliefs are trans-
lated into action. When your mind believes something, it works to make that
belief a reality.

Bill Phillips, in his book Body for Life, recounts an intriguing story about
beliefs and goal-setting. He refers to a Harvard University study that showed
that only 3 percent of the students graduating in 1953 actually wrote down
their specific career goals. Twenty years later, the study’s researchers inter-
viewed the class of 1953 and discovered that those 3 percent who had writ-
ten down their goals were worth more than the other 97 percent combined.

Successful swing traders believe they’ll succeed. They don’t dwell on their
past failures but on their past successes. They write down their goals and
their trades. They view losses as a normal part of the business of swing trad-
ing. They don’t become arrogant and overconfident when their trades gener-
ate large profits.

It helps to set specific goals, like “I will return 15 percent this year.” Write
down your goal and read it often. Yes, I know it sounds corny, but I’ve seen
this advice time and time again in investment books, physical fitness books,
and other places. And I’ve seen it work.

So begin swing trading with a winning mindset. Know that you’re going to achieve
your goals. Be optimistic. Take losses in stride and stay as unemotional as
you can. You’ll find that a winning mindset helps you become a successful
swing trader.

Part II

Determining Your
Entry and Exit

Points: Technical
Analysis

In this part . . .

Technical analysis is the time-honored tradition of
analyzing markets based on price and volume. Here,
you discover the ins and outs of reading price charts and
applying technical indicators. But with technical analysis,
you should note that more isn’t necessarily better. All
indicators are based on price and volume, so the more
indicators you apply, the more noise you hear.

Chapter 4

Charting the Market

In This Chapter

ᮣ Understanding the roles of price, volume, and the security cycle of life
in the charting world

ᮣ Getting up close and personal with four standard charting methods
ᮣ Making sense of well-known chart patterns
ᮣ Simplifying security analysis with candlesticks
ᮣ Using trendlines to guide your swing trading path

A picture’s worth a thousand words, or so I’ve heard. The stock chart
is, perhaps, the best proof of this old cliché. For centuries, charts have
assisted traders in profiting from buying and selling an underlying contract.
Candlestick charting, for example, was developed by the Japanese in the
1700s to profit from changes in the price of rice.

Over time, investors became more sophisticated in understanding charts and
the information contained within them. In fact, they became so much more
sophisticated that they started identifying certain chart patterns and giving
them funny names. Would you believe that head and shoulders is more than
just a shampoo brand, or that cup and handle applies to finances and not
just your favorite coffee container? Sure, these patterns may be the result
of investors and traders staring too long at charts. After all, I sometimes see
funny formations in clouds if I stare long enough. But they are useful tools for
your swing trading ventures.

In this chapter, I share how you can predict the likely direction of a security —
be it sideways, upward, or downward — by understanding the basic cycle of
securities and the specific roles price and volume play in what you see on a
chart. I also introduce you to several charting patterns every swing trader
needs for success. The patterns are presented in order of complexity, so
go ahead and skip straight to what you need based on your familiarity with
charting. All set? Then chart away, my friend!

60 Part II: Determining Your Entry and Exit Points: Technical Analysis

Nailing Down the Concepts: The Roles
of Price and Volume in Charting

All charts come down to basically two inputs: price and volume. The major-
ity of this chapter focuses on price, because patterns within price are more
meaningful than patterns within volume. You’re rewarded or punished for
being right on price, not volume. But I don’t want to gloss over volume. It’s a
major tool in your swing trading kit and is worth close examination.

Volume communicates conviction on the part of buyers or sellers:

ߜ A price rise on light volume may signal an absence of sellers, not the
presence of buyers.

ߜ Heavy volume, on the other hand, signals that bulls or bears are
committed to the calling.

Look to buy securities on heavy volume (exiting’s a different matter). If you’re
swing trading trends — regardless of the chart pattern you observe — insist
on seeing heavy volume. But what is heavy volume? My general rule of thumb
is that volume 1.5 times the average daily volume over the past 50 days is con-
sidered heavy. (Yahoo! Finance and most charting programs report average
daily volume statistics.) Volume can also help you determine when to exit. A
decline on heavy volume, for example, may signal that the security has farther
to fall. If you’re swing trading ranges, you want to see light volume, which indi-
cates a lack of interest by bulls and bears.

An old saying on Wall Street notes that amateurs trade at the open and pro-
fessionals trade at the close. If a security closes higher than it opened, it rep-
resents a victory of sorts for the bulls. They were able to overwhelm sellers
during the day. On the other hand, if a security closes lower than it opened,
that represents a win for the bears, who were able to overwhelm buyers
during the day. If a security closes at the same price it opened at, bulls and
bears are at a stalemate.

Major institutions that control billions of dollars are in the markets day in and day
out. They account for the majority of volume on exchanges. Security prices move
when institutions allocate parts of their portfolios to one security or another. So
you want to read how they’re investing their dollars and ride the inevitable wave
that follows as more institutions get into the bathtub. One investment wizard
I learned from — Ian Woodward — explained volume in these terms: An insti-
tution getting into a security is like an elephant getting into a tub of water.
You know the water’s going to overflow. Similarly, volume overflows when
institutions buy into or sell out of a security.

61Chapter 4: Charting the Market

Having Fun with Pictures: The
Four Main Chart Types

Reading a chart isn’t difficult, but there are different ways of viewing the same
price information, be it a line chart, candlestick chart, or bar chart. Most swing
traders choose one chart type and stick to it. The most popular chart type for
swing traders is the candlestick chart, because it reveals the most information.

To get the most value out of charting for your swing trading ventures, you
first need to be able to recognize the four main types of charts in the finance
world and how each can help you — or harm you if you’re not careful.
Following are the four main chart types and a brief description of each (from
the most common and basic to the least common):

ߜ Line chart: This chart type simply connects closes from one period to
another, and the resulting chart resembles a line. Television news programs
often show line charts because of their simplicity. However, critical data
is missing. A line chart doesn’t show you where a security opened for
the day — only where it closed. Nor does it plot the highs and lows that
occurred for each period. Line charts do, however, allow you to focus on
the most critical piece of information: the day’s closing price.

ߜ Bar chart: You’re likely familiar with traditional bar charts, which show the
open, high, low, and close of a specific security. The bar chart addresses
many of the shortcomings found in the line chart. Often called an OHLC
bar chart (which stands for, you guessed it, open-high-low-close), this chart
can provide hourly, daily, weekly, or even monthly information. Figure 4-1
shows a representation of a standard bar. A horizontal line protruding from
the left of the bar signals the security’s opening price, and a horizontal line
protruding from the right side of the bar signals the security’s closing price.
The period’s highs and lows are the top and bottom of the bar.

ߜ Candlestick chart: This chart type clearly depicts a security price’s open,
high, low, and close. Traditional bar charts do the same, but candlestick
charts do it more effectively. Candlestick charts are made up of two com-
ponents: the range between the open and close (called the real body)
and price movement above and below the body (called shadows). If the
security closes higher than its open during that period (a bullish sign), the
body is usually white. If the security closes lower than its open during the
period (a bearish sign), the body is usually black (Note: Different charting
programs use different colors to shade in the body.) When prices open
and close at the same level, the candlestick body is reduced to a horizon-
tal line, and the remaining parts are the upper and lower shadows. Figure
4-1 shows what typical candlesticks look like.

62 Part II: Determining Your Entry and Exit Points: Technical Analysis

Candlesticks are a great way to examine charts, and you can use these
patterns to assist you when entering and exiting securities. However, I
don’t know any swing traders who rely on candlestick patterns exclu-
sively. So avoid putting all your eggs in the candlestick basket. Like
every technical tool, the candlestick is an imperfect instrument. Look
for candlestick patterns as confirmation of a trend or reversal, but avoid
looking to trade a security primarily because of a candlestick chart
pattern.

ߜ Point and figure (P&F) charts: P&F charts plot security prices using a
column of Xs (to represent rising price movements) and Os (to repre-
sent falling price movements). The major advantage of P&F charts is
that they filter out noise or unimportant price movement by plotting
only new Xs and Os when the price of a security moves by a predefined
amount. One downside is that they don’t reflect the passage of time well.
Because new plots are made only when the price exceeds the predeter-
mined threshold, a plot may not be made for days or even weeks if the
security in question doesn’t move significantly.

The three charts in Figure 4-2 contrast a line chart, bar chart, and candlestick
chart. All three charts cover price action for Google (symbol: GOOG) between
December 10, 2007 and February 6, 2008. The bottom chart demonstrates a
rising trendline, which highlights a support area that, when broken, signals
the end of the uptrend. Figure 4-3 shows the other main chart type: P&F.

This book focuses on bar charts and candlestick charts, primarily the latter.
Both chart types reveal intraday or intraweek (depending on the time period
set) strength of bulls and bears, making them favored tools of swing traders
far and wide. Support or resistance areas are also occasionally easier to see
with bar charts or candlestick charts.

High High High
Close Open
Figure 4-1: Close
a) A bar Open Close
Open b. Low Low
chart. b) A
Low
candlestick

chart.
a.

63Chapter 4: Charting the Market

Line Chart

Bar Chart

Candlestick Chart

Figure 4-2:
Sample line

chart, bar
chart, and
candlestick

chart
featuring
shares of

Google.

64 Part II: Determining Your Entry and Exit Points: Technical Analysis

Figure 4-3:
A sample
P&F chart
featuring
shares of

Google.

Charts in Action: A Pictorial View
of the Security Cycle of Life

Securities go through a naturally occurring cycle, but not all securities follow
this cycle religiously. If you can’t characterize which stage a security is in,
you’re better off skipping it and finding one that’s following the normal cycle
of accumulation, expansion, distribution, and contraction. Understanding
this cycle is helpful, because different phases require different strategies.
Swing trading trends, for example, is best achieved during the expansion and
contraction phases. Trading ranges, on the other hand, is best achieved in
accumulation and distribution phases.

The waiting game: Accumulation

The accumulation phase is typically the longest phase a security goes through.
During this period, its price neither rises nor declines meaningfully. Instead,
its price moves sideways through time. Supply and demand are roughly in bal-
ance, and institutional managers or smart money often accumulate shares of
an undervalued security. (Smart money is typically institutional dollars that are
informed by extensive research.)

Volume is usually light, reflecting a general consensus that the security’s price
is correct. Buyers are unable to push prices higher than a ceiling (a resistance
level), whereas sellers are unable to push prices below a floor (a support level).
You can’t know in advance with any precision where these ceilings or floors

65Chapter 4: Charting the Market

will be found. You can easily identify them, however, by viewing a price chart
and looking for price levels that a security is unable to climb above or fall
below. These support and resistance areas are usually driven by fundamental
reasons. For example, Microsoft’s stock may not be able to rise above $35
per share because that movement represents a valuation of $300 billion, and
market participants may not feel the company is worth more than $300 bil-
lion. Thus, support and resistance levels vary by security and can’t be deter-
mined until you examine a price chart.

Think of an accumulation phase as a period where most market participants
agree on a security’s value. Because price isn’t moving dramatically, profiting
off of securities in the accumulation phase can be difficult. Some swing trad-
ers may buy at or near the support level and attempt to sell at the resistance
level. This approach only works, of course, when the distance between the
support and resistance level is sufficiently wide enough to make the profit
worthwhile. It also only works as long as the security continues to trade in the
range. If you swing trade trends, you want to look for securities moving out of
the accumulation phase and into the expansion phase. However, if you swing
trade ranges, you may be content to find accumulation phases and trade them
until the security ends its accumulation phase.

You can spot accumulation phases on charts of varying time periods. Although
accumulation phases are traditionally thought of as occurring over several
months, a security can technically be accumulated over a few days. The key
factor is time frame. A day trader, for example, looks at intraday charts where
each plot represents a five- or ten-minute interval. For day traders, accumula-
tion phases may occur over a two-day period.

As a swing trader, you shouldn’t be so close to the bushes. Although you can
use intraday charts occasionally to perfect your timing of buys and sells, your
default chart period should be measured in days. In these types of charts, an
accumulation phase must last several weeks — if not months — to be consid-
ered a true accumulation phase. Otherwise, you may be dealing with some
other phase of the cycle of the security.

Figure 4-4 highlights a typical accumulation phase when shares of Apache
Corporation (symbol: APA) oscillated between two price levels — $75 and
$60 — between October 2005 and April 2006. This wide trading range allowed
swing traders to buy at support level and sell at resistance level for profits.
However, the accumulation phase wasn’t perfect. In October 2005, shares
rose above the resistance level by a hair for a few days. And then in June
2006, shares fell below the support level of $60 by a hair.

66 Part II: Determining Your Entry and Exit Points: Technical Analysis

Figure 4-4:
The accu-

mulation
phase of

APA.

You can’t be strict on exact price levels of support and resistance and assume
a security’s price will immediately stop falling near a support level or imme-
diately stop rising near a resistance level. For example, if a security’s support
level is $35 and its resistance level is $40, you can’t assume the security’s
price will immediately stop falling when it hits $35. It may stop falling at $35.20,
$34.90, $34.75, $35.50 — well, you get the idea. Sometimes share prices don’t
reach either extreme and make turns within the two bands. Swing traders sell
long positions or enter short positions near resistance levels.

The big bang: Expansion

The expansion phase, also known as the markup phase, follows the accumula-
tion phase (see the preceding section) and is a period of increasing prices. If
the movement out of the accumulation phase is truly an expansion period, the
security’s price doesn’t reenter accumulation. So if you swing trade trends, this
is the phase where you want to go long — as soon as possible.

This phase marks the beginning of a change in perception among sharehold-
ers and outside investors. A stock expansion may occur as the earnings
outlook for a company improves. In the case of companies with a highly suc-
cessful product (think Apple and the iPod), shares may begin to rise steadily
out of an accumulation pattern after that product’s launch.

The expansion phase is ripe with profit opportunities. Swing traders who buy
right as the expansion phase gets underway often can ride a strong trend for
several days or weeks. The beauty of buying as an expansion gets underway is
that the proverbial line in the sand is clearly marked. That is, you know rather
quickly whether you bought at the right time based on whether the security’s
price reenters the accumulation phase. If you buy late, then you risk a large

67Chapter 4: Charting the Market

loss if shares of the security rapidly fall to the breakout price level — or worse —
fall back into the previous accumulation range. Use the money management
strategies outlined in Chapter 10 if you’re in this boat.

Look for strong volume at the beginning of the expansion phase as confirma-
tion that it’s genuine. If a security emerges from an accumulation phase on
weak volume, that may indicate a lack of conviction on the part of buyers.
Hence, the rally may be short-lived. For a refresher on the role of price and
volume, flip back to the earlier section, “Nailing Down the Concepts: The Roles
of Price and Volume in Charting.”

For a real-life example of what the expansion phase looks like, check out Figure 4-5,
which reflects the expansion of Apache Corporation (symbol: APA). Notice how
the breakout from the accumulation phase is on heavy volume, as highlighted
in the volume subgraph, and that shares returned to the resistance level estab-
lished in the accumulation phase. If prices had broken below that level, that’d
indicate the expansion breakout had failed. Instead, shares returned to the
breakout level and found support. This move is seen as a low-risk entry level.
Yet not all breakouts give you such a beautiful gift. Strong breakouts often don’t
return to the accumulation phase and allow reentry.

Figure 4-5:
The

expansion
phase of
APA.

The aftermath: Distribution

All good things must come to an end, including high-flying securities. During
the distribution phase, the good news that propelled shares during the expan-
sion phase is no longer so surprising to Wall Street. Share prices start to even
out and move sideways instead of rising or falling. Think of the distribution
phase as the end of the party. The music is bland, the food is stale, and the
conversations are getting old. That’s the distribution phase in a nutshell.

68 Part II: Determining Your Entry and Exit Points: Technical Analysis

The folks who built up shares of a security in the accumulation phase unload
those shares during the distribution phase. Amateur investors are often
buying the security in the distribution phase, having found out about the
company or the investment from a front cover on Forbes. When everyone
knows the story, it usually means the story doesn’t have much farther to run.

The distribution phase can resemble the accumulation phase, a misinterpreta-
tion that can seriously mess with your swing trading. Confusing the two may
prove costly when you’re expecting a higher breakout rather than a lower one.

Shares move sideways during the distribution phase, seemingly indicating a
consensus on a security’s price, and volume tends to taper off. You can tell
accumulation from distribution by

ߜ Observing that a markup phase precedes distribution, whereas a mark-
down phase usually precedes accumulation

ߜ Looking at the security’s fundamentals — typically they aren’t as strong
during accumulation

Companies can sometimes give you a hint that their shares are priced too
high. If you see one offering new stock to the public via a secondary offering,
you can be sure that management thinks shares are trading at a premium to
their true value. Also, you may see a stock split during the distribution phase.

As a swing trader, identifying distribution phases is helpful for knowing when
to exit long positions (sell securities you own) and enter short positions
(short securities you anticipate declining in value). If you spot a distribution
phase, exit immediately if you own the position. You’re likely to be stopped
out by one of your sell rules during a distribution phase: a moving average
crossover or the breaking of a predefined support level, for example. You
may also exit based on the passage of time, a strategy I present in Chapter 10.

I don’t recommend shorting during a distribution phase. Because distribution
resembles accumulation, you may short a security that’s only pausing in its
ascent. So don’t short until you see a security’s price exiting the distribution
phase and entering the contraction phase (covered in the following section).

Figure 4-6 highlights shares of Sandisk (symbol: SNDK) during a distribution
period. Notice that volume tapers off as shares move sideways. This distribu-
tion phase followed an expansion phase that occurred in June and July of 2007.

69Chapter 4: Charting the Market

Figure 4-6:
Shares

of SNDK
during a
distribution

phase.

The downfall: Contraction

The fourth and final stage of a security’s price cycle is the contraction, or
markdown, phase that’s best summarized as a period of lower highs and
lower lows, a time when short sellers rule. (For more on the earlier stages,
see the previous three sections.)

Contraction is a dangerous period. Security prices don’t fall in straight lines.
Instead, they fall, and then rally to attract new buyers who believe a bottom
has been hit. Those rallies fail, and the security moves to fresh, new lows.
Avoid timing a bottom in a security. Often termed bottom fishing, buying a
declining security may feel psychologically pleasing because you’re buying
something that was more expensive only a few days or weeks ago. But it’s dan-
gerous because shares can fall off a cliff after being in a contraction phase.

Volume isn’t a helpful indicator in periods of contraction. Although heavy
volume indicates sellers’ conviction, light volume doesn’t indicate the oppo-
site. As the old Wall Street maxim says, “A stock can fall on its own weight,
but it takes volume to rise.” Hence, a contraction period can be met with light
volume throughout.

Securities tend to fall faster than they rise. In just a few days, a security can
give up gains that it made over the last several months because greed influ-
ences price rises and fear influences price declines. Fear’s a more potent
emotion than greed. If traders fear lower prices, they sell — fast. But when
prices are rising, they’re not as committed to buying as quickly as possible.

70 Part II: Determining Your Entry and Exit Points: Technical Analysis

Rallies in a contraction phase are normal and mark entry points for short sellers.
Each rally ends at a point that’s lower than the previous one. And every decline
takes the security’s price to a new low. The prudent approach is to wait for
clear signs that the contraction phase is complete and that the security’s either
holding in an accumulation phase or entering an expansion phase. Short sellers
should short on the rallies and cover on the declines, a profitable strategy (until
it becomes so obvious that it ends). You want to have the wind at your back
when you buy a security, and buying in a contraction phase means that wind’s
going to hit you full in the face.

Figure 4-7 highlights the contraction phase in shares of Sandisk (symbol: SNDK).
This contraction followed the distribution phase highlighted in Figure 4-6. Shares
of Sandisk rallied in late October and late November as the stock broke to fresh,
new lows.

Figure 4-7:
Shares of
SNDK enter
a contrac-
tion phase.

Assessing Trading-Crowd Psychology:
Popular Patterns for All Chart Types

Highbrow academics in their ivory towers shun chart patterns because spot-
ting a head and shoulders or cup and handle can be subjective. Just like seeing
a pattern in a cloud or the stars, chart patterns are difficult to quantify. To be
proven sound, an academic needs to establish rules on spotting these chart
patterns, but programming a computer to look for patterns is difficult. Yet
reading chart patterns is an essential ability of the successful swing trader.

71Chapter 4: Charting the Market

The solution to the quandary? Trade only patterns that are clear as day. Stick
to the tried-and-true chart patterns and you’ll avoid the pain of trying to see
patterns where none exist.

The following sections describe five major chart patterns: Darvas box, head
and shoulders, cup and handles, triangles, and gaps. Rest assured that other
chart patterns exist, but these five are, in my opinion, the most common and
the most useful. They occur regularly and reflect the psychology of the crowd:
day traders, swing traders, position traders, long-term investors, and the like.

The Darvas box: Accumulation in action

The Darvas box, a rectangle-shaped pattern, illustrates that security prices
tend to trade between two levels before breaching a level and rallying or fall-
ing. You may recognize this pattern as the accumulation phase described in
the earlier section, “The waiting game: Accumulation.”

In a nutshell, the pattern’s creator, Nicholas Darvas, looked for securities
that traded between two clear price levels: a support level and a resistance
level. The support level marked the price point at which buyers stepped in
and bought shares, preventing prices from going down. The resistance level
marked the price point at which sellers stepped in and sold shares, prevent-
ing prices from going up. Darvas didn’t waste time with securities that didn’t
fit nicely into this mold.

After identifying a security as trading between the two price levels, Darvas
waited patiently until the security broke out of the upper band on heavy
volume. Then he’d buy, placing a stop loss below the support level of the
rectangle. If the security rose and formed a new rectangle, he’d raise his stop
loss level to the area below the new support level.

The Darvas box works in reverse, too. A falling security may form Darvas
boxes on its way down, so short sellers do the opposite of buyers. That is,
they identify a security trading between two price levels and then short only
after the security breaks below the support level. They place their stop loss
level right above the old support level. If a new Darvas box forms, they move
the stop loss down to the area above the new resistance level.

Figure 4-8 depicts a typical Darvas box using shares of Philippine Long Distance
(symbol: PHI) traded between two clear price levels: $30.50 and $27.30. The
excitement came on November 2, 2005, when shares broke out convincingly
above $30.50 on heavy volume. This date signaled the beginning of an uptrend
(see the later section, “Uptrend lines: Support for the stubborn bulls,” for more
info on uptrends) and marked the first time shares had exited the Darvas box,
indicating an opportune time to buy. Subsequent Darvas boxes would offer the
trader a chance to raise the stop loss level.

72 Part II: Determining Your Entry and Exit Points: Technical Analysis

Figure 4-8:
Shares of
PHI traded
in a Darvas
box in 2005.

In a similar scenario, you could’ve placed a stop loss level below the support
level of $27.30. However, I’d recommend placing a stop loss level just under
the resistance range, near $30.50. Remember: If the breakout’s genuine, the
security doesn’t reenter the Darvas box.

If you’re asking yourself why I advise adjusting Darvas’s methods, you should
know that Darvas wasn’t a swing trader. His time horizon was longer than
that of the swing trader’s, and he could afford to wait out a security. As a
swing trader, you don’t have the luxury of waiting out a security’s consolida-
tion period. Hence, the tighter stop loss level I recommend will keep you in
if the breakout is genuine and get you out if the security decides to take its
sweet time.

Dancing into the investing world: Nicholas Darvas

The Darvas box was popularized by Nicholas was a professional ballroom dancer who trav-
Darvas, a man who turned $25,000 into $2.25 eled the world performing. But in his spare
million in 18 months. What made his success time, he read books on investing and trading.
all the more remarkable was that Darvas was He stumbled onto his system after trading for
neither a stockbroker nor an investment banker. a few years and reviewing which methods
In fact, Darvas was in a profession that may be worked best.
as far away from investing as you can get: He

73Chapter 4: Charting the Market

Head and shoulders: The top-off

Not to be confused with the shampoo, the head-and-shoulders pattern is a
distribution pattern that marks the end of an uptrend, forms for psychologi-
cally based reasons, and is among the most reliable of all chart patterns.
The Federal Reserve Bank of New York even published a paper called “Head
and Shoulders: Not Just a Flaky Pattern.” The organization said that the pattern
appeared to have some predictive value and produced profits in certain markets.

The head-and-shoulders pattern is composed of three hills, with the middle
hill being the tallest and the left and right hills roughly the same height. In
this way, the hills resemble a head and shoulders, as you can see in Figure
4-9, which highlights shares of homebuilder Lennar (symbol: LEN).

In January 2007, shares rallied and met resistance at $54 per share. This occur-
rence formed the left shoulder of the head-and-shoulders pattern. Buyers
attempted to raise prices a second time and succeeded, driving Lennar’s stock
north of $56 per share. Sellers stepped in and brought shares back to the same
level as the left shoulder ($52) to complete the head. Finally, buyers attempted
once again to raise prices but were only able to push Lennar’s stock up to the
level established in the left shoulder, a move that completed the right shoulder.

Drawing a trendline through the lows of the left shoulder and the right shoulder
establishes the neckline. (Flip ahead to the last section for tips on drawing trend-
lines.) A head-and-shoulders pattern isn’t complete until a stock breaks below
this point, a movement that’s usually followed by lower prices. The head-and-
shoulders pattern is typically marked by decreasing volume, which shows a lack
of conviction among buyers.

Figure 4-9:
Shares of
LEN formed
a head-and-
shoulders
pattern in
early 2007

that sig-
naled the
beginning

of a
downtrend.

74 Part II: Determining Your Entry and Exit Points: Technical Analysis

Head-and-shoulders patterns give yardsticks as to how much a security’s
price will fall after breaking the neckline. Simply measure the distance
between the head and the neckline and project that downward to estimate
how far the stock will fall at a minimum. In the case of Lennar, the neckline
was around $52 and the head was around $56. So you could’ve expected the
stock to fall by at least $4 ($56 – $52) from the neckline ($52) and reach $48.
Lennar actually exceeded that estimate.

You should short stocks as they break below the neckline of a head-and-
shoulders pattern. Swing traders who hold shares of a company experiencing
this pattern should only exit on the break of the neckline or the fulfillment of
another selling rule.

An inverse head-and-shoulders pattern, which marks the end of a downtrend,
literally looks identical to the head-and-shoulders pattern except that it’s
turned on its head (pardon the pun). Figure 4-10 highlights an inverted head-
and-shoulders pattern in shares of Lan Airlines (symbol: LFL). The measuring
technique used in the traditional head-and-shoulders pattern applies to an
inverted pattern as well.

The cup and handle: Your signal
to stick around for coffee

The cup-and-handle pattern is a bullish one that signals shares are being accu-
mulated and the security is preparing for an upward move. Cup-and-handle
formations must be preceded by an uptrend, because they’re a continuation
formation, a pattern that indicates the continuation of a trend. (For tips on
distinguishing among trendlines, flip to the later section, “Measuring the
Strength of Trends with Trendlines.”)

Figure 4-10:
Shares of

LFL formed
an inverted
head-and-

shoulders
pattern in
July 2006.

75Chapter 4: Charting the Market

The cup and handle first forms after shares rally to some peak. Then for some
reason — perhaps fundamental or technical in nature — sellers bring shares
down 10 to 20 percent from that peak. Amateur investors who buy near the
peak kick themselves for their mistake and agonize over the 10 to 20 percent
loss on their investments. They think, “After I break even on this dud, I’ll sell.”

As it happens, shares of the security give amateur investors that opportunity
when they rally back to their previous peak. Then those disgruntled share-
holders unload the security en masse, creating a resistance level and leaving
shares unable to surpass that peak. However, shares don’t fall back to their
prior low. Instead, they remain elevated as smart money accumulates shares
at a slight discount. Shares may fall 5 percent or so from the peak at this
point. On the second attempt to surpass the peak, shares break through and
complete the cup-and-handle formation. Volume is key and should rise heav-
ily on the breakout from the handle.

Figure 4-11 illustrates a cup-and-handle pattern in shares of Compania de
Minas Buenaventura (symbol: BVN). Shares of BVN rallied to $45 per share
in July 2007. Then a general decline in the overall market helped send the
shares down to $35, representing a 22 percent loss for shareholders who
bought near the peak. Anxious to recoup their losses, these investors
unloaded their lot when shares of BVN rose near $45 in September and kept
BVN from piercing that level. But the underlying fundamentals of BVN were
strong, and investors on the sidelines didn’t let BVN decline much — only
$5 from the $45 peak. On the second attempt to break through $45, shares
sprinted higher and passed that peak on heavy volume.

My selection of numerous foreign securities in this chapter is to illustrate that
these patterns occur in both domestic and international securities. Moreover,
the greatest opportunities, in my opinion, are in foreign securities.

Figure 4-11:
Shares of

BVN formed
a cup and
handle in

2007 during
an uptrend.

76 Part II: Determining Your Entry and Exit Points: Technical Analysis

The cup-and-handle pattern isn’t as accurate as the head-and-shoulders pattern,
which I describe in the preceding section. I’ve seen it form time and time again
only to fail on the breakout. The key question to ask yourself to avoid being a
victim of a false breakout is, “What is the security’s general market and indus-
try group doing?” The stronger the security’s overall market and industry
group, the more likely the formation won’t fall flat on its face. However, if one
or the other is weak, the pattern may be prone to failure.

Triangles: A fiscal tug of war

Triangle chart patterns (shown in Figure 4-12) provide traders with measure-
ment moves, an estimate of how far the ensuing trend will travel after breaking
out from the triangle. Think of triangles as a reflection of the tug of war that
occurs between buyers and sellers. Sometimes buyers have the upper hand;
other times sellers have it; and occasionally both sides are evenly matched.

To make use of triangle patterns in your swing trading, you need to get familiar
with the three types of triangles and how to calculate price movement with each:

ߜ Ascending: Ascending triangles form when buyers maintain a level of
strength while sellers continually weaken, so buyers have the upper hand
here. Graphically, buyers maintaining their strength is reflected in prices
maintaining a certain price level. Each time sellers push prices down,
bulls step in and push shares back. Every decline stops at a higher level
than the previous decline — a sign that bears are unable to push prices
lower. Eventually, buyer strength overwhelms the sellers, and the security
breaks upward. To estimate how far, at a minimum, prices will move after
a breakout occurs, add the height of the triangle to the breakout price
level. The height of the triangle is the vertical distance between its support
and resistance levels.

ߜ Descending: Descending triangles represent the opposite of ascending
triangles. Sellers maintain their strength during the formation of the
descending triangle, and buyers continually weaken, thus giving sellers
the upper hand. Graphically, this weakening is depicted as prices falling
to a certain level and subsequent rallies ending at lower peaks. Sellers
maintain their strength during the descending triangle, while buyers are
unable to push prices to or beyond their previous peaks. Eventually,
the buying pressure dries up, and prices break downward. (Think of
descending triangles as an amateur boxer fighting a heavyweight. Try as
he may, the amateur eventually goes down.) Subtract the height of the
triangle from the breakout price level to estimate price movement after
a breakout.

77Chapter 4: Charting the Market

ߜ Symmetrical: Symmetrical triangles represent a stalemate; buyers and
sellers are evenly matched. Each rally ends at a lower peak than the
previous rally, whereas each decline ends at a higher trough than the
previous decline. You can’t easily tell who’s going to win, but you can
generally expect prices to continue in the same direction as the trend
prior to the formation of the symmetrical triangle. To estimate price
movement in this case, add or subtract the triangle’s height from the
breakout level, depending on which way prices break.

With any triangle chart pattern, be sure to watch for volume on the actual
breakout to distinguish between false breakouts and true ones.

Ascending and descending triangles are the easiest triangles to trade because
you don’t encounter ambiguity on the likely direction of the breakout. Stick to
these patterns and skip symmetrical triangles.

Ascending Triangle Descending Triangle
(Bullish) (Bearish)

Figure 4-12: ?
A depiction
of idealized Symmetrical Triangle
ascending, (Ambiguous)
descending,

and sym-
metrical
triangles.

Gaps: Your swing trading crystal ball

Gaps occur frequently in prices; they represent a break in price continuity.
For example, a security may be trading in the $19 to $20 range and then gap
up to $25. Gaps may represent a seismic shift in the fundamentals of a security,
or they may mean nothing. In this section I cover the four types of gaps.

78 Part II: Determining Your Entry and Exit Points: Technical Analysis

Common gaps

I hate to tell you this, but a common gap is meaningless. Prices gap up or down
one day but quickly “fill the gap” in a matter of days. This phrase is a simpler
way of saying the security’s price returns to the area where the gap exists. If a
security trades at $50 for several days and gaps higher to $52 the next day, its
price fills the gap by trading back down to $50. Figure 4-13 shows two common
gaps occurring in late 2006 in a chart of Diana Shipping (symbol: DSX).

Don’t trade common gaps. They typically have light volume and don’t repre-
sent conviction on the part of buyers or sellers.

Breakaway gaps

A breakaway gap occurs on heavy volume and indicates seismic shifts are
occurring in the security. Often the percentage move up or down is signifi-
cant (more than 5 percent in a single day), and the volume is at least double
the average daily volume. Breakaway gaps are preceded by congestion peri-
ods. A security’s price trades for several weeks or months in a certain price
area and then violently gaps higher or lower one day. The strength of the
move indicates a major change is occurring in the way investors value the
security. Figure 4-14 highlights a breakaway gap using shares of Contango Oil
& Gas Company (symbol: MCF).

Breakaway gaps don’t necessarily require swing traders to immediately buy
or sell, because several things can happen after the gap, and the gap has to
be confirmed. So if you think you see a breakaway gap, take note, but wait for
confirmation.

Figure 4-13:
Common
gaps
appeared

in shares of
DSX in late

2006.

79Chapter 4: Charting the Market

Figure 4-14:
This chart of
MCF shows
a consolida-

tion period
followed
by a clear

breakaway
gap.

Continuation gaps

A continuation gap crops up in the midst of an uptrend or downtrend and
signals — you guessed it — the continuation of the previous trend. Figure 4-15
highlights a continuation gap that followed a breakaway gap in shares of
Flowserve Corp. (symbol: FLS). Note: Not all continuation gaps are preceded
by a breakaway gap.

Some swing traders actually estimate how far a security will rise or fall based
on the price appreciation or depreciation from the beginning of a trend until
the continuation gap, and then project that forward. This approach can be
somewhat subjective. Instead, look to add or enter a position on a continua-
tion gap in the direction of the gap (for example, buy if the gap is up and short
if the gap is down). Place a protective stop loss within the gap. If the gap is
truly a continuation gap, shares don’t return to fill it.

Figure 4-15:
FLS shares

form a
continuation

gap.

80 Part II: Determining Your Entry and Exit Points: Technical Analysis

Exhaustion gaps

An exhaustion gap, which occurs in the direction of a trend, resembles a
continuation gap and marks the end of that trend. If a security has been fall-
ing for several weeks and then gaps down, you may think that gap is a con-
tinuation gap. However, if the gap fills quickly, it’s likely an exhaustion gap.
Figure 4-16 offers an example of an exhaustion gap occurring at the end of an
uptrend in shares of Sigma Designs (symbol: SIGM).

The exhaustion gap doesn’t offer any call to action for you as a swing trader.

Figure 4-16:
An exhaus-

tion gap
appears in
a chart of

SIGM.

Letting Special Candlestick Patterns
Reveal Trend Changes

You can find dozens of candlestick chart patterns out there, but I cover
only the ones I feel are most accurate. The next four sections feature candle-
stick chart patterns that are easy to identify and that may signal a change in
momentum or a continuation of a trend. (For help discerning one trend from
another, flip ahead to “Measuring the Strength of Trends with Trendlines,”
later in this chapter.)

Hammer time!

A hammer represents the bottom of a trend. It looks identical to a hanging
man (see the following section) and occurs at the end of a downtrend.

81Chapter 4: Charting the Market

Hammers have small real bodies in the upper portion of the candlestick bar.
They have long lower shadows and small upper shadows (if any). Hammers
signal that after the price of the security opened on the market, sellers drove
it down. By the end of the day, buyers had recouped much of the losses to
end the day near or at the high.

I like to see hammers that extend below recent price action. If a hammer
occurs within the price action of previous days, I don’t consider it a reliable
indicator of a bottom.

Figure 4-17 sheds some light on the difference between a hammer that forms
below recent price history and one that forms within price history using
shares of Western Digital (symbol: WDC), which bottomed on April 10, 2007.
Notice how the high and low on that bottoming day were well below recent
price history. Contrast this hammer formation to the apparent hammer that
formed on March 14, 2007. This second hammer’s body was within previous
price action, but ultimately, it didn’t mark the bottom of the downtrend.

No hammer is complete without confirmation. If the price action directly after
the hammer is down, then no hammer has occurred. A true hammer can’t
have its low violated by subsequent price action. So watch to see how subse-
quent days unfold before trading a hammer so as to avoid whipsaws.

Volume, again, should be kept in mind. Hammers that form on heavy volume
are usually genuine, whereas those that form on light volume probably aren’t
the real McCoy.

Figure 4-17:
Shares
of WDC

represent
a clearly
defined
hammer
on April 10,

2007.

82 Part II: Determining Your Entry and Exit Points: Technical Analysis

The hanging man (Morbid, I know)

A hanging man looks identical to the hammer (see the preceding section).
However, it occurs at the end of an uptrend rather than a downtrend. It crops
up on heavy volume and is followed by price action confirming the top. If the
high of the hanging man is surpassed, then its signal is invalid.

Double vision: Bullish and bearish
engulfing patterns

My favorite candlestick charting patterns are the bullish and bearish engulf-
ing patterns, which involve two candlestick bars, not one.

Bullish engulfing patterns occur when a candlestick bar opens lower than the
previous candlestick’s close and closes higher than the previous candle-
stick’s open. In candlestick terminology, the pattern begins with a candlestick
bar that has a small real body and is followed by a candlestick bar whose
body engulfs the previous day’s body.

Why is this pattern so bullish? It represents a major defeat, so to speak, for
bears. When the second candlestick bar opens, sellers are already pushing
prices below the prior day’s close. However, buyers step in and begin pur-
chasing en masse. Not only are they able to reverse the direction from the
open but they also manage to push prices higher than where sellers began
the previous day. Think of a bullish engulfing pattern as a surprise victory in
a battle where an infantry division loses not only the gains it made in the pre-
vious day but also much more.

I’ve found bullish engulfing patterns to be accurate (otherwise I wouldn’t be
covering them). Look for subsequent price action to confirm the reversal. If
prices trade below the pattern, you can bet your bottom dollar that the
pattern failed.

Figure 4-18 highlights a bullish engulfing pattern in shares of NewMarket
(symbol: NEU) that fell in mid-2006 from $62 to less than $40. Notice how the
open on June 14, 2006, completely engulfed the entire body of the prior day.
Subsequent price action confirmed the bottom.

Bearish engulfing patterns occur at the end of uptrends and mark important
reversals. They’re characterized by two bar formations. The first candlestick
consists of a small real body. The second candlestick opens higher than the
previous bar’s close and closes lower than the previous bar’s open, thus
engulfing the first candlestick. Figure 4-19 highlights a bearish engulfing pat-
tern that formed in shares of Diamond Offshore (symbol: DO) in late 2007 and
signaled the end of the prior uptrend.

83Chapter 4: Charting the Market

Figure 4-18:
Shares of
NEU form
a bullish
engulfing
pattern.

Wait for confirmation before shorting a bearish engulfing chart pattern since
not all bearish engulfing patterns lead to lower prices. If the engulfing pattern
is genuine, prices should decline after the formation and shouldn’t exceed the
high of the bearish engulfing bar.

Figure 4-19:
Shares of
DO formed
a bearish
engulfing
pattern in

late 2007 to
mark the
end of an
uptrend.

The triple threat: Morning
and evening stars

Morning and evening stars are reversal chart patterns that consist of three
candlesticks. Morning stars mark the end of a downtrend and the beginning of
an uptrend. Evening stars mark the end of an uptrend and the beginning of a
downtrend.

84 Part II: Determining Your Entry and Exit Points: Technical Analysis

A morning star occurs at the end of downtrends, which means that sellers (the
bears) are in force prior to the reversal, and consists of

ߜ A long, black-bodied candlestick that pushes the downtrend lower

ߜ A second candlestick that gaps lower at the open (but doesn’t necessarily
have to be completely below the first candlestick) and forms a small body

ߜ A long, white-bodied candlestick that gaps higher from the second
candlestick and closes near the upper portion of the first candlestick

Conversely, an evening star occurs at the end of uptrends, reflecting the last
gasp of buyers (the bulls), and is made up of

ߜ A long, white-bodied candlestick that pushes the uptrend higher

ߜ A second candlestick that gaps higher at the open (but doesn’t necessarily
have to be completely above the first candlestick) and forms a small body

ߜ A long, black-bodied candlestick that gaps lower from the second
candlestick and closes near the lower portion of the first candlestick

Figure 4-20 is an example of an idealized morning and evening star. Both
patterns reflect the inability of the ruling party, bulls or bears, to consolidate
previous gains. The star (the middle bar) is an exhaustion attempt by buyers
(in the case of an evening star) or sellers (in the case of a morning star) to
push prices definitively higher or lower, respectively. That’s why the second
bar in the morning or evening star formation is small: The day begins with a
gap in the direction of the trend, but the initial enthusiasm dies down. The
third bar shows a swing in momentum as bulls or bears take over.

Figure 4-20: Evening Star Reversal
The morn- (Bearish)

ing star and

evening star
patterns. Morning Star Reversal
(Bullish)

To see one of these star patterns in the context of a chart, take a look at
Figure 4-21, which shows the evening star reversal in action in shares of
China Mobile Limited (symbol: CHL) in February 2007. Notice how the star
(the middle candlestick in the formation) gapped higher than the previous
bar. The third bar represented a resounding defeat for bulls, as bears were
able to push prices to the level of the first candlestick.

85Chapter 4: Charting the Market

Figure 4-21:
Shares
of China
Mobile
Limited
(symbol:

CHL) formed
an evening
star in
February of
2007.

Measuring the Strength of
Trends with Trendlines

Quite literally, trendlines connect price points together and form either a hori-
zontal, rising, or falling line. They’re helpful in establishing support and resis-
tance levels. When a trendline breaks, shares may or may not reverse course.
The most you can take away is that the trend in question has ended. A consoli-
dation period (sideways movement) may follow, a continuation of the trend
may arise, or the trend may reverse. All three scenarios are possible.

The stock market isn’t some perfect universe where stocks stop and rally on a
dime. There are gray areas, and trendlines should be drawn through them. Of
course, trendlines aren’t perfect either and may at times intersect with prices.
But if trendlines are valid, these intersections shouldn’t be significant (in how
deeply they intersect) or often (the number of times they intersect with prices.)

Much ink has been spilt on the construction of trendlines, but there’s really
no science to them. So don’t expect one trendline drawn at an angle of 65
degrees to be right and one drawn at 63 degrees to be wrong. The basics of
drawing trendlines can be summarized in three simple rules:

ߜ A trendline must touch three different price points to be valid.
Otherwise, you can draw a line pretty much anywhere.

86 Part II: Determining Your Entry and Exit Points: Technical Analysis

ߜ The more times a trendline’s touched, the stronger the support or
resistance of that line. A break of a trendline that had been tested
several times indicates a serious change in the trend.

ߜ The longer the trendline (measured by time), the more meaningful it
is. The staying power of the trend is measured, in part, by how long the
trendline has been in effect.

If you find yourself drawing and redrawing trendlines (on your charting
program, not by hand), then you’re misusing them.

Don’t waste too much time drawing trendlines. Instead, identify support and
resistance levels, which are often horizontal lines. Then look for an uptrend
or downtrend line that you can draw through the lows or highs to establish a
rate of ascent.

In the following sections, I share how to distinguish and use different trendlines.

Uptrend lines: Support for
the stubborn bulls

Uptrend lines connect several lows and form a support area for the bulls —
the bulls’ line in the sand, if you will. They indicate the rate of ascent that
buyers have maintained over a certain period of time. If your charts are
arithmetically scaled, then the rate of ascent is measured in dollars per time
period. If your charts are semi-log or plotted on a log scale, then the rate of
ascent represents a percentage change per time period.

You want to draw your uptrend line through the lows, but don’t take it to an
extreme. If the line intersects prices slightly, that’s okay. Consider Figure 4-22,
which shows an uptrend line of shares of Sandisk (symbol: SNDK). The uptrend
line is drawn through the lows and touches several price points. On an extreme
day in the beginning of August, prices fell below the line but basically remained
above the trendline. Hence, the trendline stayed intact.

Uptrend lines can be good long entry points for your swing trading. Not only
do they offer an entry price but they also offer a clear risk-cutting price. Place
a stop loss right below the trendline so that you exit shares if the trendline
breaks.

Uptrend lines have another important characteristic: These support lines
become resistance lines after being breached. Look again at Figure 4-22. In
mid-August, shares of Sandisk broke below the uptrend line that began in
June. When shares rallied in September, that support line became a resistance
area. After shares rallied to that trendline, they immediately turned around
and began declining.